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Can China Regain Its Edge?

When the financial crisis struck the United States back in 2008, China gloated over the “failure” of the Western World’s free market system. At the time, it appeared Beijing’s model of controlled intervention was right. But almost five years later, China—the world’s “growth engine”—is stalling. The nation’s growth rate slowed to 7.4% during the third quarter, and Chinese stocks have lost around 30% over the past five years. Can China lead the world back to growth?

China 101

The People’s Republic of China is home to 1.3 billion people and governed by the Communist Party of China—a single party state. Beijing is the capital city and the government exercises its power over 22 provinces, five autonomous regions, four directly controlled areas (Beijing, Tianjin, Shanghai, and Chongqing), and two self-governing regions (Hong Kong and Macau).

China is the world’s second largest economy and is renowned for its ability to produce goods cheaply. Its low labor costs, favorable government policies, and undervalued exchange rate have helped it to stay a fierce competitor. As of 2012, the International Monetary Fund (IMF) estimates that China’s GDP was approximately $7.298 trillion.

Global steel production is dominated by China, which accounts for around 44% of all output. For energy production, coal produces about 70% of China’s energy needs and in 2010 the country became the world’s largest producer of wind energy.

Perhaps no trend more closely illustrates China’s development into an economic juggernaut than its shift from a nation of bicycles to cars. The country is now the world’s largest auto market, recently supplanting both Japan (2006) and the United States (2009).

No Decoupling

Although the theory of economic decoupling forecasted that fast growing emerging market countries would be largely shielded from economic problems in developed nations, reality hasn’t followed theory.

Three years after the U.S. financial crisis and the start of Europe’s sovereign debt crisis, China, like other emerging countries is stalling. The IMF projects China’s economy to average 5.8% in the half-decade through 2016, almost two percentage points less than the five years before the 2009 slump.

A one percentage point drop in China’s growth rate often leads to a 1.5 point decline in commodity prices over a couple of quarters. Here too, there’s no decoupling, because large natural resource producers like Australia and Canada get hit.

Domestic Demand Model

Can China’s domestic economy make up for the global slowdown?

Like the theory of economic decoupling, certain economists promoted the idea that domestic consumption by China’s large population would minimize the impact of slowing demand for Chinese exports. But thus far, it hasn’t worked out that way. China’s weak third quarter economic expansion takes it back to 2009’s level.

Additionally, China’s growth is slowing because household spending as a percentage of its own output is sliding. “The growth model which has worked is running out of steam because consumption as a percentage of GDP has fallen,” said billionaire George Soros at the National Association for Business Economics conference in New York. Soros estimates the decline in domestic consumption from one-third of output—down from half.

Another overlooked issue is one of demographics. The proportion of Chinese citizens over age 60 is growing at a faster rate compared to other age groups. After three generations of a one-child policy, China’s aging population will limit future productivity in coming decades. The government plans to keep the one-child policy through 2020.

China will have to re-evaluate its export-focused growth model by making its domestic economy a more significant part of the overall picture.

Chinese ETFs

For advisors, there are many roads to China. The iShares FTSE China 25 Index Fund (FXI) has almost $6 billion and is the best known China equity ETF. The large cap fund is the dominated by domestic financials, energy and the telecom sectors.

“Like most Chinese funds, earnings for FXI will be about flat this year. But the firms in the fund have a slightly better long-term record of profit growth versus their counterparts in the broader emerging markets area, yet they’ve gone from a valuation premium to a discount in recent years,” said Michael Krause, president of AltaVista Research. Over the past five years, FXI has underperformed its emerging market peers by 14.8%. Krause has a “speculative rating” on FXI due to its high concentration on just a handful of stocks and estimates 6.2% EPS growth in 2013.

For a core China position, the SPDR S&P China ETF (GXC) is an ideal choice. The fund offers broader exposure to Chinese equities because its 217 holdings also include mid and small caps. GXC’s largest three sectors are financials (31.8%), energy (14.8%), and technology (13%). GXC has outperformed FXI over the past one, three and five years and the fund’s annual expense ratio is 0.59%.

A deliberately undervalued yuan has become a major sticking point between China and its major trading partners. The depressed yuan has contributed to massive trade surpluses and Chinese exports swelled to $186.35 billion in September, or almost 10% higher compared to the same time last year. How much longer will the globe tolerate China’s unfair advantage? If China’s trading partners go to war by reducing imports or debasing their own currencies, the effect on China’s economy would be adverse.

Over the past year, the People’s Bank of China has cut interest rates twice and lowered bank reserve ratios three times. Yet, compared to Europe and the U.S., monetary stimulus in China has been much less aggressive. The People’s Bank of China Deputy Governor Yi Gang said that while policy makers will provide “appropriate” stimulus to maintain growth, the central bank’s main focus is price stability versus stoking inflation and asset bubbles.

What happens if China can’t achieve adequate growth targets? Then Western World-styled QE could become China’s future. Oh the irony! But judging how European and U.S. financial markets have reacted to the stimulus spending by their central banks, China following the same path might not be such a bad thing.

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